The Employee Ownership Update

Corey Rosen

September 9, 2002

IRS Revenue Procedure Limits Most S Corporations to Calendar Year

On May 10, 2002, the IRS issued Revenue Procedure 2002-38, in which it clarified that under Section 1378 of the Internal Revenue Code, an S corporation's taxable year must normally be its calendar year. There are exceptions for fiscal years other than calendar years if approved by the IRS, one of which appeared to provide an automatic approval for plans adopting the fiscal year of the sole owner (such as an ESOP). Many S corporation ESOPs retained the fiscal years they used when they were in C corporations, relying on this automatic approval process. The new revenue ruling, however, requires that these companies now switch to a calendar year. Only plans that had specifically requested IRS approval for non-calendar years would be grandfathered. It is not clear if the IRS will allow companies who will have to pay double taxes in a year due to the change in their fiscal years to spread the payments over a longer period of time.

SEC Requires Companies to Allow Shareholder Proposals on Stock Plans

The Securities and Exchange Commission has ruled that companies cannot exclude shareholder proposals under the Rule 14a-8 exclusion that allows companies to avoid shareholder votes on proposals dealing with "ordinary business matters," such as employee compensation. Some companies had been relying on this rule to preclude shareholder votes on equity plans that were broad-based. A prior SEC ruling had allowed this interpretation, but the new ruling reverses this stand in cases where the plan would result in "material dilution." Similar proposals have been made by NASDAQ and the NYSE, but the SEC proposal would apply to all public companies, wherever they are traded. The change was based on the SEC's conclusion that the social and economic environment had changed, making equity compensation an issue beyond ordinary business. For more details, go here.

Management Corporation ESOP Rejected

In a case that could have implications for efforts to set up S ESOP Corporation management companies, a U.S. Court of Appeals for the Eighth Circuit found that a management corporation's ESOP did not meet the coverage requirements of ERISA and revoked the plan's qualification (Beals Brothers Management Corp. v. Commissioner, 8th Cir., No. 01-3922, 8/27/02). Beals Brothers Management Corporation was set up to manage Beals Brothers Manufacturing. In 1987, the management company set up an ESOP for its four employees. It then bought the stock of the manufacturing company and merged with it. The two companies maintained separate ESOPs, but the manufacturing company's plan received almost no contributions, while the management company's plan received more significant contributions. A tax court ruled that the plan failed to meet the minimum coverage requirements of ERISA. The court concluded that the ESOP set up by the four owners for the management company "used management fees...to fund its plan." This arrangement, it said, "seems contrary to the broad participation objective" of ERISA. The court found that the two companies were members of the same controlled group, and thus must treat all employees as employees of the same employer. The company argued it should be able to aggregate the two plans, but the court concluded that to do that "the proportion of qualifying employer securities to total plan assets" would have to be substantially the same.

While this case does not involve an S corporation ESOP, its structure is reminiscent of current proposals to use ESOP tax advantages primarily for a small group of managers in a company. The history of this case suggests the IRS and the tax courts will not look kindly on plans designed to subvert the broad participation rules of ERISA.